By David Damiani, CPA, J.D., Manager
With all of the new financial regulations going into effect after the worst economic downturn since the Great Depression, it’s no wonder the government may now keep a closer eye on all aspects of private industry – and S corporations are no exception.
Recently, S corporations have come under scrutiny in the Senate, specifically with the amendment to the American Jobs and Closing Tax Loopholes Act of 2010. While Senate Finance Committee Chairman Max Baucus, D-Mont., has scaled back interest in S corporation tax provisions, the government is still planning to pay closer attention to the financial handling of S corporations.
With significantly more small businesses in operation than large conglomerates – and the majority of those small businesses operating as an S corporation – owners need to understand innumerable rules they must follow if they are to stay on the good side of the Internal Revenue Service (IRS).
Why S Corps Are So Popular
Reduced exposure to payroll taxes may encourage a small business owner to organize an S corporation rather than an LLC or other passthrough entity. Active participants in an LLC or partnership are subject to the 15.3% self-employment tax (equivalent to employer and employee shares of Social Security and Medicare) on their entities’ passthrough net income. This is not the case for S corporation owners. However, an actively participating owner of a profitable S corporation is expected to pay himself or herself a “reasonable” wage, subject to payroll and unemployment taxes.
Naturally, an S corporation shareholder has an incentive to reduce his or her wages, allowing a larger portion of corporate net income to pass through free of payroll taxes; and to take a larger portion of compensation via (usually) nontaxable corporate distributions. The IRS is well aware of this strategy, and has increased scrutiny of S corporations that pay less than “reasonable” compensation to their active shareholders. Current or prospective S corporation shareholders should take notice of this trend.
What is “Reasonable Compensation?”
The IRS is specifically empowered to adjust S corporation income to reflect reasonable compensation. It may deem corporate distributions or unenforced “loans” to be disguised income and therefore subject to back payroll taxes, on which it will impose interest and potentially severe penalties (for failure to file and deposit, and possibly negligence). Although it may challenge excessive compensation (such as attempts to shift income to family members who are less involved in the corporation’s activities), it more commonly focuses on minimized compensation.
Therefore, any S officer or shareholder of a profitable S corporation who provides more than minor services should receive a reasonable wage. IRS provides no definition of “reasonable,” but its guidance and various court cases detail the major factors used in evaluating reasonableness. These include hours worked, duties performed, complexity and size of the business, corporate compensation policy, consistency of a shareholder’s salary history, economic conditions, and directly comparing the wages and distributions a shareholder receives. In essence, in exchange for the benefit of escaping self-employment tax on other corporate net income, IRS seeks to ensure that S corporation shareholders receive a wage that reflects the fair value of services rendered.
Recent Developments
The Service is increasingly interested in comparing wages to distributions. A 2002 Treasury Inspector General Report recommended aggressive review of S corporation shareholder compensation, citing 84 S corporations under audit in which average officer wage was $5,300 compared to average distributions of about $350,000.
Once IRS almost exclusively focused on S corporation returns that reflected no shareholder compensation, but recent developments such as the 2010 Iowa District Court case David E. Watson, P.C. v. U.S. herald that S corporation shareholders who pay themselves living but far-below-market wages no longer elude scrutiny.
The Watson case concerned a CPA who paid himself an annual wage of $24,000 while taking distributions over $200,000 in one year. The Court noted that Watson’s monthly living expenses exceeded his wages and that a similarly situated full-time CPA could expect a substantially greater salary in an arm’s-length negotiation. It therefore dismissed Watson’s motion for summary judgment on IRS’ conclusion that over $67,000 per year of his distributions be reclassified as wages.
Several factors in Watson command close attention. First, it demonstrates that the IRS is targeting far less blatant offenders than the textbook shareholders who paid themselves no compensation and/or argued that they formalized an “employment contract” establishing little to no salary. Also noteworthy, Watson lost his challenge despite having followed corporate formalities such as documenting his salary in the corporate minutes.
Lessons for S Corporation Shareholders
Now more than ever, as noted in the frequently cited S corporation compensation case Spicer Accounting Inc. vs. U.S. (1990), salary agreements between a closely held corporation and its shareholders warrant close scrutiny. S corporation shareholders should critically examine whether the salaries they take are sufficient, and should be sure to pay reasonable salaries 1) when the corporation has the capacity to do so and 2) before making distributions.
It remains wise to document salaries and the nature and magnitude of services rendered in the corporate minutes, and increasingly vital to evaluate whether salaries are reasonable, on an arm’s-length basis, in proportion to hours worked and living expenses. Shareholder loan bona fides should be established with valid, enforceable, documented agreements to diminish the possibility that a loan may be reclassified as wages.
Despite IRS’ increased scrutiny, the S corporation entity form continues to offer the same payroll tax minimization advantages as in the past. Closer attention to shareholder compensation should not be interpreted as an assault on the S corporation concept; it represents only expanded corrective action against those who improperly exploit these advantages.
When consulting with an attorney and CPA about choosing an entity form, these tax advantages may help to make an S corporation the right choice for a business owner. But a business owner needs to be mindful of political developments, as increasing budget deficits have aroused speculation that the S corporation self-employment tax exemption may be repealed. And while it’s hard to predict the future and what the end result will be concerning S corporations, one thing is certain: stick to current IRS and government-mandates concerning taxing and the handling of S corporations to avoid any sticky situations.
David Damiani, CPA, J.D., is a Manager with Witt Mares, PLC. Witt Mares is a regional public accounting and business consulting firm headquartered in Newport News, VA, with offices in Fairfax, Richmond, Norfolk, and Williamsburg.